Three Costliest Estate-Planning Mistakes

Fewer than 5% of doctors have an adequate estate plan; for those who do, the upcoming tax-law changes may create even more shortfalls. Here's how to avoid the three biggest -- and most costly -- estate-planning mistakes physicians typically make.

Changes in tax laws can catch people off guard. With most physicians so busy worrying about potential reimbursement reductions, many don’t have the time to address the important challenge of establishing a tax-wise estate plan for their families. In our experience, fewer than 5% of doctors have an adequate estate plan in place. This upcoming tax-law change will create even more shortfalls in most physician families’ planning.

When it comes to estate planning, doctors typically make one or more of these three common mistakes:

• Unnecessarily losing up to 50% of life insurance proceeds to taxes;

• Leaving too much value in the taxable estate; or

• Losing up to 70% of the value in a qualified retirement plan or IRA.

Fortunately, there are a few simple tools doctors can use to help circumvent such mistakes and allow their families to avoid the unnecessary costs that come with poor estate planning.

Losing Half of Life Insurance Proceeds to Taxes

Financial consultants highly recommend using life insurance as a tool to pay the estate taxes that may be due when a physician dies. The funds are available immediately to surviving family members, without the delays or expenses involved in liquidating tangible assets. Nonetheless, many physicians fail to establish a simple trust that, if done properly, enables all of the proceeds from a life-insurance policy to be estate tax-exempt and available to a surviving spouse at the same time.

One common misconception people have about life insurance is that all insurance proceeds are exempt from estate taxes. This is not true. Life-insurance proceeds are exempt from income tax, but they are subject to both federal and state estate taxes. Federal estate-tax rates, now and under current proposals, would likely be about 45% to 50%, and surviving family members also would need to pay individual states’ estate and inheritance taxes on these proceeds. Physicians’ family members need not lose such a large percentage of the life-insurance proceeds when a simple legal tool can solve this problem and provide better lawsuit protection for insurance beneficiaries.

A good way to avoid losing a significant portion of life insurance proceeds -- or possibly any proceeds at all -- is to establish an irrevocable life-insurance trust. As the name implies, it’s a trust that owns a life-insurance policy. The trust can eliminate estate taxes on the proceeds because the trust -- rather than the physician or his or her family -- owns the policy. Since the policy is not held in the doctor’s name, the policy proceeds will not be part of his or her net estate at the time of death -- as long as the physician survives three years from the time of the transfer to the trust. The proceeds, therefore, are not subject to estate taxes. This type of ownership is ideal for estate planning, but not for those tax-savvy investors who are using life insurance to generate tax-efficient retirement wealth.

The irrevocable life-insurance trust gives the insured much more control over what happens to the policy proceeds than he or she would get from a beneficiary designation of an insurance policy. With an insurance policy alone, the only decisions the insured can make is to whom to leave the proceeds and whether to pay all the money out in a lump sum or over a specific period of time (with an annuity payout option).

With an irrevocable life-insurance trust, however, the insured can control not only who receives the proceeds, but also exactly what happens to the funds when he or she dies. The trust can require the trustees to pay the beneficiaries immediately in a lump sum, or pay them over months or years -- with more creativity than a beneficiary designation offers. The insured can also incorporate spendthrift provisions and anti-alienation provisions to protect the surviving family members against their own financial problems or their spouse’s financial woes. The irrevocable life-insurance trust offers tax reduction, asset protection, and planning creativity that cannot be achieved with a simple beneficiary designation.

For these reasons, every physician should consider an irrevocable life-insurance trust when purchasing a life insurance policy that is to be used as part of a well-crafted estate plan. The cost for setting up such as trust can run anywhere from $2,000 to $4,000.

For physicians who have already purchased a life insurance policy, or who are currently making payments on an existing policy, it is not too late to establish such a trust. A policy can be transferred to an irrevocable life-insurance trust at any time. There may be some gift-tax issues associated with such a transfer, but these issues are likely to be minor compared with the potential tax savings.

Leaving Property to the IRS

We do not know of any physicians who have left property to the Internal Revenue Service intentionally. If the physician or his or her estate has not implemented a gifting program in the doctor’s lifetime, the end result is often the same. After a certain exemption amount (which is set to return to $1 million in the upcoming years), any property not given away during a physician’s lifetime will likely be taken in part by the IRS. To prevent having to make this payment, physicians can gift property to family members.

Most physicians initially hesitate to begin a gifting program, believing that they will have to give up control of the underlying assets. But control of the assets is not necessarily given up in such programs. Instead, a physician can use legal entities to remove asset values from his or her estate, and still maintain complete control of the assets while still alive.

Through such entities as family limited partnerships and family limited liability companies, physicians can share ownership of their property with family members and maintain control of the property at the same time. Using this strategy, the physician and his or her spouse can give as gifts ownership interests to their children over time, using their combined annual gift-tax exclusions. Doing so removes those interests from their estates for tax purposes. But as long as the physician and the spouse are the general partners in the family limited partnership or the managers of the family limited liability company, they will maintain control of the underlying assets. The cost for setting up this type of asset-protection strategy can be anywhere from $5,000 and up.

Taxes Unnecessarily Consuming 401(k)s and IRAs

A large chunk of the assets in pensions, 401(k)s, and IRAs could end up being owed to state and federal tax agencies when a physician dies. It is an unpleasant truth that after paying taxes for a lifetime of work, a physician’s tax qualified plans could be taxed at rates above 70 percent. The good news is that there are techniques that can be incorporated to avoid this loss of wealth. While such techniques are too involved to be described in a short article, with advanced planning the threat of taxes decimating a qualified plan can be eliminated. A professional financial consultant can examine qualified plans and advise clients on which strategies will save them the greatest amount of their wealth.

Many physicians put their families in an estate-planning mess because of these three common mistakes. Clients with larger estates have even more potential pitfalls to avoid in their planning. While educating yourself regarding the potential errors in the estate planning arena is important, as in the practice of medicine, there is no substitute for a consultation with an experienced, licensed professional. An estate-planning physical with a financial planner is the real first step in any worthwhile estate plan.

Christopher Jarvis and Jason O’Dell are principals of the financial consulting firm O’Dell Jarvis Mandell LLC. Jarvis and Mandell have co-authored seven books for doctors. They are speakers for Guardian Publishing, who offer CME seminars and other programs for groups, hospitals and societies. The authors welcome your questions. You can contact them at (877) 656-4362 or through their website. For a copy of "For Doctors Only: A Guide to Working Less and Building More" (free, plus $5 shipping and handling), please call (877) 656-4362.

Disclosure: This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein. Pricing ranges are for informational guidelines only and prices for more complex circumstances may exceed these published ranges. For additional information about the OJM Group, including fees and services, send for our disclosure statement as set forth on Form ADV using the contact information herein.